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The bouncing ball was an animated device used in the old Fleischer Studio films in the mid-twentieth century. Words to a song were displayed on the screen and a little ball would bounce from one word to the next to illustrate the rhythm of the music so the audience could sing along. I still remember old reruns of these films that would play on the local UHF station during the summer when I was growing up.

The market also has a rhythm, though it can become quite discordant from time to time, and it’s a little more difficult to follow the bouncing ball. The S&P 500 has been choppy since the beginning of the year, and although the pullback in January wasn’t that deep, the rhythm of highs and lows could result in a head-and-shoulders pattern. Option traders should prepare for this possibility without getting out of sync and taking action too early.

One way to assess the probability that a pattern will be completed is by using confirming indicators. The head-and-shoulders pattern is comprised of three peaks, with the middle peak being the tallest. Ideally, the peaks on the right and left should be roughly the same size and shape, but that isn’t an absolute requirement. The pattern is a bit rare, but it happens often enough that even the Federal Reserve (arch fundamentalists) admits it is predictive for market direction.

The S&P 500 formed a head-and-shoulders pattern before the big decline in the spring of 2012, and before the crash in August of 2011. In the next chart, you can see what the hypothetical completion of a head-and-shoulders pattern would look like on the S&P 500 if stocks begin to reverse again. The pattern would be completed if prices cross below the neckline that connects the two shoulders.

S&P 500 (SPX): Chart courtesy of MetaStock Professional

As you can see, there is quite a bit of distance between where the S&P 500 (SPX) is now and where it needs to be for to complete a bearish reversal pattern like the head-and-shoulders. However, there are other indicators that can also provide early warning signs that a pattern is more likely to be completed.

Transports and Small-Caps Lag the Market

Transportation stocks and small-caps are often a good measure of investor sentiment. If indexes of those stocks are leading when the market rallies, then sentiment is strong and the bullish trend is more likely to continue. However, when they lag (or complete their own head-and-shoulders pattern), it is a strong warning that the broad market indexes are likely to struggle as well.

For example, in the next chart, you can see the contrast between the Transportation and Russell 2000 (small-cap) indexed ETFs. In both cases, it is clear that they have been lagging the recent rally in the S&P 500 and remain below the November/December highs. More conservative groups, as well as Apple (AAPL), have been leading the charge, which indicates weakness. The transportation index is the closest to completing its own head-and-shoulder pattern.

It is premature to get too worried about a major reversal in the market, but this is the first time we have been this close since 2012. It’s also not urgent to take action immediately. Unless there is an unexpected catastrophe, the head-and-shoulders pattern isn’t likely to complete until next week — if it ever does. However, making a plan to deal with a correction like that still makes sense.